Determining a Partner’s Interest in an Investment Fund Partnership When an Allocation Lacks Substantial Economic Effect

Tax Strategist Insight

Many investment fund partnership agreements include income and loss allocation provisions that are driven by distribution rights but do not provide explicit instructions regarding a partner’s share of realized profit or loss. These “targeted allocation” agreements often reference an intent to achieve ending capital account balances commensurate with future distributions, with profit and loss allocations determined accordingly.

From a tax perspective, existing partnership allocation rules provide significant flexibility in determining allocations among partners. However, with this flexibility comes a high degree of uncertainty. Tax law requires allocations that do not have what is known as “substantial economic effect” (SEE) to instead be made in accordance with the “partner’s interest in the partnership” (PIP). Unfortunately, Treasury and the IRS have provided little guidance for determining PIP. On IRS examination, this lack of guidance can lead to significant complexities under the existing partnership audit regulations, including imposition of imputed underpayment obligations, interest charges, and possible penalties.

What is Substantial Economic Effect?

The Internal Revenue Code provides that an allocation described in a partnership agreement will be respected only if the allocation qualifies as having economic effect, and the economic effect is substantial. Whether an allocation has SEE must be evaluated annually. In the absence of SEE, the partnership must determine each partner’s distributive share of partnership income or loss based on PIP.

Economic effect. An allocation of partnership income or loss will have economic effect if it commensurately affects the partner’s economic position. Treasury regulations set forth three safe harbors intended to give taxpayers certainty that an allocation of partnership income or loss will have economic effect: the general test, the alternate test, and economic effect equivalence. An allocation will satisfy either the general or the alternate test of economic effect only if:

• The partnership maintains capital accounts in accordance with the rules of Section 704(b);
• Upon liquidation of the partnership, liquidating distributions are required to be made to the partners in accordance with positive balances in their capital accounts; and
• The partnership agreement contains one of two types of provisions that require partners to make contributions or receive special allocations of income to eliminate a deficit capital account balance: (i) a “deficit restoration obligation” (DRO) in the case of the general test; or (ii) a “qualified income offset” (QIO) in the case of the alternate test.

To have economic effect equivalence (the third safe harbor), allocations made to a partner that do not meet the general or alternate test will still be deemed to have economic effect if a liquidation of the partnership at the end of the current year, as well as at the end of any future year, would produce the same economic results to the partners as if either the general or alternate test were satisfied.

Substantiality. The regulations also provide guidance on when economic effect will and will not be considered substantial. In general, the economic effect of an allocation is substantial if there is a reasonable possibility that the allocation “will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences.” However, the economic effect of an allocation is not substantial if, as compared to the consequences absent the allocation (and measured on a net present value basis):

• The after-tax economic consequences of at least one partner may be enhanced; and
• There is a strong likelihood that the after-tax economic consequences of no partner will be substantially diminished.

In other words, allocations that serve to reduce the partners’ collective tax liability lack substantiality. The regulations focus on two specific situations that may be viewed as lacking substantiality: (i) allocations of items of income or loss that reduce the partners’ collective tax liability without substantially affecting the economic effect among the partners (shifting allocations); and (ii) situations in which one or more allocations will be largely offset by one or more other allocations (transitory allocations).

Many Fund Agreement Allocations Lack Substantial Economic Effect

Although Treasury and the IRS have provided extensive guidance, the rules surrounding SEE remain complex, and many fund agreement allocations will not meet any of the safe harbors for economic effect. First, funds generally do not liquidate in accordance with capital account balances. Second, fund agreements typically provide that no partner shall be unconditionally obligated to restore a negative capital account balance; thus, most fund agreements do not contain a DRO. Third, it is unlikely that the fund’s allocation provisions have economic effect equivalence, which requires assurance that liquidation of the partnership, in any year, will result in partner distributions matching their capital account balances. Such assurance is often impractical and generally may be unreliable.

Challenges in Determining Allocations Based on PIP

As previously mentioned, when an allocation in a partnership agreement does not have SEE, the partnership must determine the allocation based on PIP. Despite the importance of defining PIP, the rules and examples found in Treasury regulations provide relatively little guidance for taxpayers. This uncertainty leaves allocations open to potential IRS scrutiny and challenge.

The regulations generally provide that PIP should reflect, based on all relevant facts and circumstances, “the manner in which the partners have agreed to share the economic benefit or burden (if any) corresponding to the income, gain, loss, deduction, or credit (or item thereof) that is allocated.” The regulations further provide the following nonexclusive list of facts that will be considered in determining PIP:

• The partners’ relative contributions to the partnership.
• The interests of the partners in economic profits and losses (if different from that in taxable income or loss).
• The interests of the partners in cash flow and other nonliquidating distributions.
• The rights of the partners to distributions of capital upon liquidation.

Special rule. The regulations also provide a special rule for determining PIP, according to which a partner’s allocations are generally determined with reference to changes in the partner’s right to capital following a hypothetical sale of the partnership’s assets at book value and a subsequent hypothetical liquidation of the partnership. However, the special rule applies only if (i) the partnership maintains capital accounts in accordance with Section 704(b); (ii) the partnership agreement provides for liquidation of the partnership in accordance with positive capital account balances; and (iii) all or a portion of an allocation of income or loss does not otherwise have economic effect under the general or alternate safe harbor test.

Fundamental challenges in determining PIP. Partnerships — especially investment funds — face complex challenges and uncertainties when determining PIP, which may include the following:

• Investment funds often have multiple business and economic considerations that strongly affect the determination of PIP. Given this, PIP may not always correspond to the overall economic arrangement of the partners but can vary for individual items of income, gain, deduction, or loss.
• The economic arrangement among the partners in a fund is generally not defined by a single tax year, and future uncertainty can affect the economic arrangement over time. Therefore, PIP should not be viewed as static and may change over the life of the partnership.
• In practice, the special rule described above for determining PIP is unlikely to apply in many fund allocation structures because fund agreements typically do not require liquidation according to positive capital account balances. The method described in this special rule is often leveraged to determine partner “targeted” allocations when reference to changes in partner capital accounts drives the allocation.
• While the special rule may provide a reasonable method of allocation, the other factors delineated in the regulations should be considered when determining PIP. A holistic view of these factors may result in a PIP determination that is more consistent with the overall economic agreement of investment fund partners.

The Importance of Capital Account Maintenance

The capital account maintenance rules are fundamental to determining the potential supportability of partnership income or loss allocations. Allocations made by partnerships that do not maintain partners’ capital accounts in accordance with the rules of Section 704(b) cannot have economic effect. In addition, the determination of PIP relies in part on a partner’s economic entitlement to partnership capital.

Treasury regulations provide that proper maintenance of partner capital accounts requires upward and downward adjustments for specific items including contributions by the partner to the partnership; distributions from the partnership to the partner; allocations of items of partnership income, gain, loss, deduction, and certain partnership expenditures; and other adjustments such as required revaluations of partnership property in certain situations.

Conclusion and Further Reading

The determination of PIP is based on facts and circumstances; therefore, each situation needs to be separately addressed. In the absence of additional guidance, the best strategy in preparation for IRS examination may be a detailed, clearly documented assessment of each taxpayer’s particular facts supporting the determination of PIP. For additional analysis, practical insights, and a comprehensive case study, see Jeffrey N. Bilsky, “Investment Fund Allocations: Defining a Partner’s Interest in a Partnership,” Tax Notes Federal, July 8, 2024, p. 195.

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